Wednesday, October 28, 2009

Inflation and stock prices.

I've been checking out a new blog on Reuters by a Rolfe Winkler. It's pretty good, although his recent posting on inflation and stock prices makes the common mistake of confusing nominal and real growth rates. In economics parlance, we call this inflation or money illusion.

The basic error of inflation illusion is that a nominal discount rate is used to present value a firm's cash flows while a real growth rate is used to grow them. The result is that when inflation increases, the discount rate goes up and the present value of cash flows declines. This leads to the oft-cited conclusion that stock prices will decline when inflation increases.

In fact, stocks are natural hedges against inflation because the cash flows are real. This means that they increase with inflation. As prices go up, the firm's revenue and cash flows increase accordingly.

At the simplest level, consider the Dividend Discount Model.

P = D1/r-g

D1 is the dividend expected next year. r is the nominal discount rate and g is the growth rate. An increase in inflation will increase r through the risk free rate. g will also increase at the rate of inflation. Because the numerator is r-g, the effect of inflation will cancel out.

Mr Winkler is not alone in suffering from inflation illusion. The effect has been well documented. The original idea of inflation illusion affecting stock prices was proposed by Franco Modigliani and Richard Cohn in 1979. Since then, numerous academics have studied the issue and found evidence of inflation illusion. For example, John Campbell and Tuomo Vuolteenaho find evidence in their American Economic Review paper in 2004. Yours truly also found evidence for inflation illusion in my 2002 Journal of Financial and Quantitative Analysis with Jay Ritter.

Inflation illusion also affects house prices, but that's a topic for another day...

Friday, October 23, 2009

Air freight and stock prices...

In my undergrad investments class we've been talking about efficient markets and how new information arrival is random. This new information is then rapidly incorporated into stock prices.

Here's an interesting example. On Monday Apple reported its quarterly earnings and let slip that it is paying for abnormally high air freight that is not iphone related.

Hmmm, what could this be for?

Of course, analysts are speculating that the company is prepping for the imminent release of a tablet computer.

This is a perfect example of new information that was not expected by the market, but that would have a material effect on the stock price.

Monday, October 19, 2009

Google's bandwidth bill is probably not zero.

Here's a good question for finance students. Based on this article, is Google's bandwidth bill for youtube really zero?

The article argues that Google has soooo much fiber optic cable that it basically trades bandwidth with other ISPs and never pays for bandwidth. So if you're doing a cash flow analysis on youtube would assume that band width cost was really zero?

For a bonus, use the words "opportunity cost" and "sunk cost" correctly in your answer.

What about China and the US Government debt?

Twice in the past couple of weeks I have been at some social event (usually involving beer) and have been asked "what about China and all the US debt it keeps buying?"

This article discusses the issue nicely.

I also need to drink beer with less serious people.

HT: Greg Mankiw

Smart guys on wall street...

Q. What caused the financial meltdown?

A. Too many smart guys on wall street.

Or so says this entertaining article...


HT: My friend Robert

Monday, October 12, 2009

Trouble with stock options, part deux

We've heard plenty about the option backdating scandal in which firms retroactively awarded stock options at the lowest stock price of the quarter.

Well now there appears to be a new, but related scandal brewing. The WSJ discusses a new study by Fich, Cai and Tran at Drexel U. who find that firms that are in merger negotiations are pretty liberal with their option grants.

They allege that when negotiations about a merger are being quietly made, the target firm grants options to the CEO of the target. Then, when the merger is announced the stock price will most likely go up and the CEO makes out.

One possible explanation is that you want to incent the CEO to get the best possible price from the merger, and options will do that. But as is pointed out in the article, the CEO's pay package should already provide the correct incentives if it is well constructed.

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High Frequency Trading and the small investor

High frequency trading is the process of using powerful computers to exploit the smallest inefficiencies in stock prices. The Wall Street Journal has a good primer on the topic here.

One of the problems of HFT is that the little guy can get mowed down by the massive trades put on by HFT algorithms. Matthew Goldstein of Reuters discusses one such case.

As my undergrad students should know, a stop loss order is really just a market order to sell that is waiting to be triggered. The key risks with a stop loss is that it will either get triggered by a gyration in the stock or that it will trigger far below the original order price because the stock is moving so fast. This is precisely what happened in the case discussed by Goldstein, who says...

The lightening fast selling triggered a so-called stop-loss standing order Watson had with his broker to sell Dendreon shares if the stock fell into the low $20s. But the stock fell so fast that the broker didn’t actually sell Watson’s 1,500 shares until the price had hit $15


What to take away? If you are an individual investor trading stocks on your own, you are swimming with the sharks. Nothing good will come of it. You should be indexing.


HT: Felix Salmon

Saturday, October 10, 2009

How risky are stocks?

The widely held view that stocks are not risky in the long run is attacked by a nice article in today's WSJ.

It states:
Look at the long-term average annual rate of return on stocks since 1926, when good data begin. From the market peak in 2007 to its trough this March, that long-term annual return fell only a smidgen, from 10.4% to 9.3%. But if you had $1 million in U.S. stocks on Sept. 30, 2007, you had only $498,300 left by March 1, 2009. If losing more than 50% of your money in a year-and-a-half isn't risk, what is?

Executive Pay

David Yermack, an NYU finance prof, has an excellent article in today's WSJ about executive pay. Yermack has been critical in the past of executive compensation - he wrote a very interesting article about the uses and abuses of corporate jets.


His article today makes a simple and often overlooked point. You have to include the value of past stock and option grants when figuring out how execs are compensated. You cannot just focus on this year's salary.

Many executives lost massive amounts of personal wealth when their company stock prices collapsed. No one feels bad for them as this is true pay for performance. Shareholders lost money and so did they.

Overall Yermack concludes that CEO compensation contracts work pretty well and the current witch hunt, which might be good for the media and some political careers, really won't make things better.

Thursday, October 8, 2009

Nobel Prize for Economics

Given that the Nobel for Economics is to be announced on Monday, I thought it might be nice to see who has won it in the past...

Here's the list

Wednesday, October 7, 2009

Do TIPs provide inflation protection...?

TIPS - Treasury Inflation Protected Bonds are designed to provide inflation protection to investors. These US government bonds have par values that increase at the rate of the CPI each year. Because the par value increases, the coupon payment also increases. Thus the payment you get is, in effect, indexed to inflation.

Jeff Opdyke of The Wall Street Journal asks - "do these bonds provide inflation protection?" Its a good question, however I think that Opdyke's analysis has some problems.

First he points to the fact that the CPI is an imperfect measure of inflation. This is absolutely true, for example the CPI doesn't include extra bag fees for airlines. But I disagree that a flaw in the index is that it doesn't include borrowing costs. The CPI specifically doesn't include borrowing costs, in part because using a cost that is directly related to inflation in the index would lead to a feedback loop. Furthermore, when mortgage rates increase, the higher borrowing costs are offset by house price appreciation - so it is unclear whether a household's costs have truly increased.

A second point raised is that if you sell the bonds before they mature, you are not guaranteed the promised return. As my students should know, this is incorrect. To earn the initial yield to maturity you need to hold bonds whose duration is equal to your holding period. Holding the bonds to their maturity exposes you to reinvestment risk from the coupons. Zvi Bodie has talked about this issue and advocates target date duration matched TIPs funds for retirement.

Finally, Opdyke argues that 3% tips would underperform 5% tips in an environment where rates increase. We have to be careful here. If the rate increase is just due to higher inflation, then there will be no difference in the real return on these bonds. But if the increase reflects a higher real rate of interest, then the lower coupon bonds will be hurt more because they have a higher duration.

Overall though, this is an interesting article and well worth a read.